CHICAGO -- Fitch Ratings warned it would downgrade $5.7 billion of Detroit's water and sewer debt to as low as D if the bankruptcy court approves the city's current plan of debt adjustment.

The city's proposed treatment of its water and sewer debt would, if approved, be considered a distressed debt exchange, said Fitch. The plan would refinance and restructure the bonds.

The deal would strip existing call provisions, reduce interest rates and subordinate debt service to an annual payment to the city, among other things.

"Fitch would likely view the court's confirmation of the POA as filed on May 5, 2014 as a distressed debt exchange leading to a ratings downgrade as low as 'D'," the ratings firm said in a note on the water and sewer bonds.

There is no legal reason for bondholders to accept such impairments, analyst Adrienne Book wrote.

Fitch currently rates the senior-lien water and sewer bonds BB-plus and the second-lien debt BB. The note confirms that the ratings agency is keeping the debt on negative watch.

A trial on Detroit's bankruptcy confirmation plan is currently set to begin July 24.

Bondholders who vote against the plan would receive different bonds with a lower interest rate than their existing coupons, Fitch noted. Bondholders who vote for the plan would receive bonds with the same coupon rates, but would have no call protection.

The negative watch on the water and seer bonds is due to the uncertainty surrounding the fate of the debt in the bankruptcy court. Fitch continues to assume that the debt, as revenue bonds, will be protected from impairment under Chapter 9 code.

"Nonetheless, there remains uncertainty surrounding the city emergency manager's attempt to impair system bondholders under the city's fourth amendment plan of adjustment," Booker said.

On top of the legal uncertainty, the city's water and sewer system -- which serves nearly half of Michigan and is one of the largest in the country -- continues to show a weak financial performance, Fitch said. Fiscal 2014 debt service is expected to fall below projections. The system's failure to maintain "at least breakeven operations" will also likely lead to a downgrade, analysts said.

Fitch noted that the system lost its second-largest water wholesale customer in April when the city of Flint moved to its own system.

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